28-1

Chapter Twenty Eight

Cash Management
Corporate Finance
Ross Westerfield Jaffe

28

Sixth Edition

Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-2

Executive Summary
Cash management is not as complex and
conceptually challenging as other topics, such as
capital budgeting and asset pricing.
Financial managers in many companies, especially
in the retail and services industries, spend a
significant portion of their time on cash
management.
Most large Canadian corporations hold some of
their assets in cash and marketable securities.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-3

Chapter Outline
28.1 Reasons for Holding Cash
28.2 Determining the Target Cash Balance
28.3 Managing the Collection and Disbursement of
Cash
28.4 Investing Idle Cash
28.5 Summary & Conclusions

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-4

28.1 Reasons for Holding Cash

Transactions motive:
Transactions related needs come from normal
disbursement and collection activities of the firm.
The disbursement of cash includes the payment of wages
and salaries, trade debts, taxes, and dividends.
The cash inflows (collections) and outflows
(disbursements) are not perfectly synchronized, and some
level of cash holdings is necessary to serve as a buffer.
Perfect liquidity is the characteristic of cash that allows it
to satisfy the transactions motive.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-5

28.2 Determining the Target Cash Balance

The target cash balance involves a trade-off between
the opportunity costs of holding too much cash (lost
interest) and the trading costs of holding too little.
If a firm tries to keep its cash holdings too low, it
will find itself selling marketable securities more
frequently than if the cash balance were higher.
The trading costs will tend to fall as the cash
balance becomes larger.
The opportunity costs of holding cash rise as the
cash holdings rise.
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-6

28.2 Determining the Target Cash Balance

The Baumol Model
The Miller-Orr Model
Other Factors Influencing the Target Cash Balance

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-7

Costs of Holding Cash

Costs in dollars of
holding cash

Trading costs increase when the firm

must sell securities to meet cash needs.
Total cost of holding cash
Opportunity
Costs
The investment income
foregone when holding cash.
Trading costs
C*

McGraw-Hill Ryerson

Size of cash balance

2003 McGrawHill Ryerson Limited

28-8

The Baumol Model

F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
K = The opportunity cost of holding cash: this is the interest
rate.
If we start with $C,
spend at a constant rate
each period and replace
C
our cash with $C when
we run out of cash, our
average cash balance
C
will be C .
2
2
The opportunity cost
of holding C is C K
2
2
1
2
3 Time
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-9

The Baumol Model

F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
K = The opportunity cost of holding cash: this is the interest
rate.
As we transfer $C each
period we incur a trading
cost of F each period. If
C
we need T in total over the
planning period we will
pay $F, T C times.
C
2

1
McGraw-Hill Ryerson

Time

The trading cost is

T
F
C

2003 McGrawHill Ryerson Limited

28-10

The Baumol Model

C
T
Total cost K F
2
C

C
Opportunity Costs K
2

Trading costs

T
F
C

C*
Size of cash balance
The optimal cash balance is found where the opportunity
costs equal the trading costs
2T
*
C
F
2003 McGrawHill Ryerson Limited
K
McGraw-Hill Ryerson

28-11

The Baumol Model

The optimal cash balance is found where the opportunity
costs equal the trading costs
Opportunity Costs = Trading Costs

C
T
K F
2
C
Multiply both sides by C

C2
K T F
2

T F
C 2
K
2

2TF
C
K
*

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-12

The Miller-Orr Model

The firm allows its cash balance to wander
randomly between upper and lower control limits.
$

When the cash balance reaches the upper control limit H cash
is invested elsewhere to get us to the target cash balance Z.

Z
L

When the cash balance

reaches the lower
control limit, L,
investments are sold
to raise cash to get
us up to the target
cash balance.

Time
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-13

The Miller-Orr Model Math

Given L, which is set by the firm, the Miller-Orr
model solves for Z and H
2

3F
Z
L
4K
*

H 3Z 2 L
*

where 2 is the variance of net daily cash flows.

The average cash balance in the Miller-Orr model
is
4Z * L
Average cash balance
3
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-14

Implications of the Miller-Orr Model

To use the Miller-Orr model, the manager must

do four things:
1.
2.
3.
4.

Set the lower control limit for the cash balance.

Estimate the standard deviation of daily cash flows.
Determine the interest rate.
Estimate the trading costs of buying and selling
securities.

The model clarifies the issues of cash

management:

The best return point, Z, is positively related to

trading costs, F, and negatively related to the interest
rate K.
Z and the average cash balance are positively related
to the variability of cash flows.
2003 McGrawHill Ryerson Limited
McGraw-Hill Ryerson

28-15

Other Factors Influencing the

Target Cash Balance
Borrowing
Borrowing is likely to be more expensive than selling
marketable securities.
The need to borrow will depend on managements desire
to hold low cash balances.

Relative costs
For large firms, the trading costs of buying and selling
securities are very small when compared to the
opportunity costs of holding cash.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-16

28.3 Managing the Collection and

Disbursement of Cash
The difference between bank cash and book cash is
called float.
Float management involves controlling the
collection and disbursement of cash.
The objective in cash collection is to reduce the lag
between the time customers pay their bills and the
time the cheques are collected.
The objective in cash disbursement is to slow down
payments, thereby increasing the time between
when cheques are written and when cheques are
presented.
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-17

Electronic Data Interchange

Electronic Data Interchange (EDI) is a general term
that refers to the growing practice of direct,
electronic information exchange between all types
of businesses.
One important use of EDI is to electronically
transfer financial information and funds between
parties, to eliminate paper invoices, paper cheques,
mailing, and handling.
One of the drawbacks of EDI is that it is expensive
and complex to set up.
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-18

Accelerating Collections
Customer
mails
payment

Company
receives
payment

Company
deposits
payment

Cash
received

time
Mail
delay

Processing
delay

Clearing
delay

Mail
float

Processing
float

Clearing
float

Collection float
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-19

Overview of Lockbox Processing

Corporate
Customers

Corporate
Customers

Post Office
Box 1

Corporate
Customers

Local Bank
Collects funds
from PO Boxes

Corporate
Customers

Post Office
Box 2

Envelopes opened;
separation of
cheques and receipts
Details of receivables
go to firm

Deposit of cheques
into bank accounts

Firm processes
receivables

Bank clears cheques

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-20

Electronic Collection Systems

Focus on reducing float virtually to zero by
replacing cheques with electronic funds transfer.
Examples used in Canada:

Preauthorized payments
Point-of-sales transfers
Electronic trade payables
Smart cards.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-21

Controlling Disbursements
Firms use zero-balance accounts to avoid carrying
extra balances in each disbursement account.
With a zero-balance account, the firm, in
cooperation with its bank, transfers in just enough
funds to cover cheques presented that day.
The firm maintains two disbursement accounts: one
for suppliers and one for payroll.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-22

Ethical and Legal Questions

The financial managers must always work with
collected bank cash balances and not with the
companys book balance, which reflects cheques
that have been deposited but not collected.
If you are borrowing the banks money without their
knowledge, you are raising serious ethical and legal
questions.
The issue is minor in Canada since there can be a
maximum of only one days deposit float.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-23

28.4 Investing Idle Cash

A firm with surplus cash can park it in the money
market.
Some large firms and many small ones use money market
mutual funds.
Canadian chartered banks compete with money market
funds offering arrangements in which the bank takes all
excess available funds at the close of each business day
and invests them for the firm.

Firms have surplus cash for three reasons:

Seasonal or Cyclical Activities
Planned Expenditures
Different Types of Money Market Securities
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-24

Seasonal Cash Demands

Total Financing needs
Bank loans
Marketable
securities

Short-term
financing

Long-term
financing
J
McGraw-Hill Ryerson

Time
2003 McGrawHill Ryerson Limited

28-25

Characteristics of Short-term Securities

Maturity
Longer maturity securities are more exposed to interest
rate risk than shorter maturity securities.

Default risk
DBRS compiles and publishes ratings of various
corporate and public securities.

Marketability
No price-pressure effect
Time.

Taxability
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-26

Some Different Types of Money-Market Securities

Money-market securities are highly marketable and shortterm.
They are issued by the federal government, domestic and
foreign banks, and business corporations.
Examples are:

T-bills
Commercial paper
Bankers acceptances
Dollar swaps

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-27

28.5 Summary & Conclusions

A firm holds cash to conduct transactions and to
compensate banks for the various services they
render.
The optimal amount of cash for a firm to hold
depends on the opportunity cost of holding cash and
the uncertainty of future cash inflows and outflows.
Two transactions models that provide rough
guidelines for determining the optimal cash position
are:
The Miller-Orr model
The Baumol model
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-28

28.5 Summary & Conclusions

The firm can make use of a variety of procedures to
manage the collection and disbursement of cash in
such as way as to speed up the collection of cash
and slow down payments.
Some methods to speed collections are
Lockboxes
Concentration banking
Wire transfers

The financial managers must always work with

collected company cash balances and not with the
companys book balance.
McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited

28-29

28.5 Summary & Conclusions

If you are borrowing the banks money without their
knowledge, you are raising serious ethical and legal
questions.
The answers to which you probably know by now.

McGraw-Hill Ryerson

2003 McGrawHill Ryerson Limited